We don't like to stereotype people, and every investor should have their own needs understood and an appropriate investment plan put in place accordingly. However, we see certain personal investing habits cropping up repeatedly, in particular among entrepreneurs. We highlight some of these investing pitfalls below, explain why they represent a poor strategy, and suggest potential solutions.
Common investing pitfalls entrepreneurs make:
* Overconfidence. Behavioral finance studies how our emotions affect our behaviors with regards to our investments. As humans it's hard to avoid, so it's important to be aware of it. Overconfidence is just one of many aspects of behavioral finance. It describes how we may overestimate our knowledge, underestimate risks, and exaggerate our ability to control events. This may occur when a person is familiar with a certain area or sector and therefore believes they should invest in what they know the best. However, in doing this, investors may well be missing out on better opportunities in other sectors, and end up overconcentrated in certain sectors. This is particularly relevant to entrepreneurs as often they exhibit overconfidence in personal investing in the same area in which their business is present, which leads to a concentration of business and personal exposure.
* Lack of diversification. One result of overconfidence is a lack of diversification. We believe that diversification is the best way to generate risk-adjusted returns through the cycle. We have found that some entrepreneurs are too focused on one asset class, currency, or country, thereby potentially missing out. Additionally, an investment portfolio can be used to counteract some of the potential vulnerabilities in their core businesses. For further details on this, please see the CIO report "How to diversify as a business owner," published 2 July 2019.
* Lack of focus on risk tolerance. Some entrepreneurs may have a high risk tolerance, since it has been necessary to take greater risks than others to make their businesses succeed. Those running their own business are probably well aware of the risks they are taking. In personal investing, however, some entrepreneurs think about the returns and forget to consider the risk profile of their portfolio, either taking too much risk, or perhaps even too little.
* Keep it liquid too long. Some entrepreneurs, having built and sold a business, are then prone to keeping the assets realized from the sale in liquid form too long. While it is totally correct to take time and properly think through an investment plan, keeping assets in cash for too long is undesirable. It may create an inclination to spend more than intended, and the cash value may be eaten away by inflation. Some solutions to these issues are to consider allocating a portion of assets to illiquid investing, and also to use wealth planning to control access to capital. This is best when combined with asset class diversification to capture the full range of risk premium available as well as the illiquidity premia. For further thoughts on this topic, please see the CIO report "How should investors deal with lump sums?" published 10 February 2019.
* Buy too many depreciating assets. One side-effect of keeping money liquid for too long is the temptation to buy too many depreciating assets such as boats, houses, planes, and cars. While we believe there is a role for such assets within a total portfolio, consideration also needs to be given to the longevity of the wealth, and how best to allocate for that. Some passion investments, while they are generally depreciating assets, may also rise in value over time. So a considered assessment of how much of the wealth to allocate to such assets and how much to income-generating assets is worthwhile. Generating some regular income, particularly after a business is sold and a salary is no longer present, is an important factor for entrepreneurs to consider.
* Forget to use Liquidity. Longevity. Legacy. (3L)* framework. UBS believes in an approach where wealth is segmented into various "buckets." Spending needs for the next two to five years should be held in cash-like instruments. The Longevity portion should contain enough assets to generate income and returns for living needs in the investor's lifetime. The remainder of the wealth can be allocated to a Legacy plan that focuses on longer-term investments, for example for subsequent generations or philanthropic purposes. Such a framework is the crux of a well-thought-through investment plan, and instrumental in helping to decide the correct asset allocation. Asset allocation forms the majority of a portfolio's risk and return. For further details on this framework, please see the CIO report "Liquidity. Longevity. Legacy. A purpose-driven approach to wealth management" published in September 2018.
* Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.
* Try to do everything themselves. How many entrepreneurs like to be in control? Having built up their own successful companies, some entrepreneurs seem to try to do everything themselves. While people who have the knowledge, time, and focus to spend on their personal investments may well be thorough in looking after their personal wealth, many others do not. Even for those with the right knowledge, the most common problem is not allocating enough time to managing their personal wealth plan and investments, or indeed getting too bogged down in detail and losing sight of the bigger picture. Those who know little about investing would clearly be better off taking some advice.
* Forget to plan properly for tax payments. Tax payments due on the sale of a business, or indeed annual tax payments thereafter, can sometimes go unplanned for, particularly if they are due in different currencies. Financial planning should be an inherent part of everyone's personal investment plan. As part of this, investments can be structured to pay out in time for tax payments, and the use of financial planning vehicles such as enterprise investment schemes or venture capital trusts (or equivalent financial planning vehicles in other jurisdictions) may also be worthwhile.
* Forget investment capital is at work as much as business capital. While every entrepreneur will be very aware of how every dollar is invested in their business, they often forget to think about how their personal investment capital is being spent. When we invest in financial markets, our capital is out there being used by the organizations we give it to. As investors, we can choose how that capital is spent by focusing, for example, on sustainable investments.
We hope you are an entrepreneur who has read this and thought, "That's great, I don't make any of those common investing mistakes!" If not, we hope it has interested you as a call to action. You can find more details in our CIO publication, "Uncommon success: Wealth strategy for entrepreneurs and business owners," published March 2019.
Author:
Caroline Simmons, CFA, Strategist, UBS AG
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Appendix
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